Too Big to Manage? Or Too Badly Managed to be Big?

There can’t be too many people who don’t realize that the investment banking industry is in a fair old pickle right now.

Those who have eyes to see can observe individual firms floundering, those with mouths to speak will struggle to name a bank that isn’t facing difficulties (even the once omnipotent J.P. Morgan – like a financial Ozymandias – has been humbled), and those with brains must therefore deduce that the industry is broken. But there is nothing like having the hard facts laid out to really hammer home the point.

Cue a report published last week by McKinsey. The consultancy paints a warts-and-all portrait of the investment banking industry encompassing research on 212 firms around the world. And, boy, it sure ain’t pretty. McKinsey estimates that the average cost of equity for the capital market operations of most banks is around 12%. And yet the investment banking industry only managed to achieve an average return on equity of 10% in 2012.

The picture is even worse for the 13 largest investment banks, which generated more than half of industry revenues last year. Their average cost of equity is about 13% but their collective return on equity last year was only 8%.

This means that, five years on from the credit crunch and with the global economy beginning to recover, investment banks are still roaring through their shareholders’ money like drunken sailors on shore leave.

And the McKinsey report (like a Thomas Hardy novel) makes it clear that a bad situation can always get much, much worse. McKinsey estimates that new regulations – especially those relating to derivatives, market risk measures, ring-fencing, the financial transaction tax, and, of course, the new capital rules enshrined in Basel III – could result in the average return on equity for the entire investment banking industry dropping to 5% by 2019. For the 13 biggest banks, it could drop to 4%. (Just to confirm: that’s “4” as in “four”, I didn’t accidentally miss a digit off.)

What this highlights is that – despite all the strategic decisions that have been made, all the risk-weighted assets that have been shed, and all the jobs that have been axed – we are far closer to the beginning of this generational shake-out in the investment banking industry than we are to the end. Bank executives seem not yet to have fully got their heads around the problems they face, far less begun to fashion the solutions.

So what’s to be done? Well, for starters McKinsey thinks that costs need to fall by another 25%, which broadly means that a quarter of the jobs in the industry have to go. But another clue is right there in the title of the McKinsey report: “The Return of Strategy”, which somewhat implies a prolonged absence of said commodity.

For the past 30 years most banks chanced their arms at any and all business opportunities that held out the vaguest possibility of making money. At different times, some things paid off and some didn’t. But, before the credit crunch at least, enough of those business lines were making enough money to cover for those that weren’t.

That’s not a strategy; it’s throwing mud against a wall to see what sticks. And the inefficiencies it bred, which were long disguised by outsized returns, have now been laid bare. Disassembling the money machines that were gradually patched together during the boom years is a fraught task. So far the efforts by the banks to reduce their costs have failed to keep pace with the decline in revenues. McKinsey calculates that revenues among the largest investment banks have fallen 10% a year since 2009; costs are down by an average of just 1% a year.

Senior bank executives have been left in charge of a ridiculously complex hodgepodge of different businesses that make no coherent strategic sense. They are impeded by business models based on increasingly defunct notions of asset class and management teams that are highly skilled at defending their own fiefs. This has suckered many banks into trying to do everything for the biggest clients rather than working out what they’re best at and providing that to as broad a client base as their reach allows.

The result is the polar opposite of differentiation: if you were to line up most large investment banks, strip them of their logos and subject them to a blind taste, you’d be hard pressed to tell them apart.

Rather than dividing their world into fixed income and equities or cash and derivatives, banks should restructure themselves around capabilities. The four that McKinsey suggests make sense: the electronic trading of standardized products, building bespoke risk management solutions, providing funding, and offering advice. There will be a tiny handful of banks that will be able to do all four of those things profitably for a wide range of clients in most parts of the world. The rest must be content to master one or two in the locations where they’re strongest, for the clients they know best.

It will take enormous upheaval to get from here to there. McKinsey doesn’t, of course, have all the answers. Those have to come from the management teams of the investment banks. But, with a few faint exceptions, there is very little compelling evidence that any real answers are forthcoming.

Lots of people have argued that the largest investment banks are too big to manage. Perhaps it is more accurate to say they have, to date, been too badly managed to be big.

Write to ben.wright@wsj.com and follow @_benwright_

This commentary first appeared in sister title Financial News. More comments this week, including J.P. Morgan lessons on investment banking, and why talented women are leaving the workforce, on its comment page.

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